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Termination payments

20th November 2017

Over the past four years both the Office of Tax Simplification and HM Revenue & Customs have been reviewing the tax treatment of termination payments.

The proposed legislation was “abandoned” earlier this year, a victim of the General Election hiatus. However, the draft tax legislation was published in September, has recently been debated before the House of Commons Finance Select Committee and will come into effect from 6 April 2018.

What are the changes?

Currently, the tax treatment of a payment in lieu of notice (PILON) will be dependent upon whether or not there is a contractual right to receive a PILON. Where the employment contract includes a clause binding the employer to make a payment on the employment being terminated, then for tax and National Insurance purposes it will be treated in the same way as general earnings (salary).

However, some employment contracts do not make a provision for the payment of a PILON. Where this is the case and the employment contract is being prematurely terminated then a breach of contract will have occurred. Under the current legislation the payment can be made tax free, up to a limit of £30,000, the excess will be liable to tax. However, no National Insurance liability is due on any part of the PILON regardless of the amount due to be paid.  

The new legislation will seek to impose a charge to tax on “post-employment notice pay”, in other words the proportion of the termination payment based upon the notice period. The charge will apply whether there is a contractual obligation to make a payment. Fundamentally, the charge will only apply to basic pay, although there are anti-avoidance provisions to prevent the suppression of earnings, for example, changing basic into a bonus.

The following example helps to demonstrate how a termination payment will be taxed based upon whether it is paid before 6 April 2018 (Table 1) and after 6 April 2018 (Table 2).

Summary of facts

  • An employee has a termination payment made up of:
    • Compensation for loss of office - £20,000
    • Non-contraction PILON - £15,000
  • They have a base salary of £60,000, a notice period of three months.
  • No post termination benefits are provided.
  • Employee will have a post-employment notice payment (‘PENP’) of £60,000 x 90/365 = £15,000 (rounded) 

Table 1 - Position prior to 6 April 2018

Details

Amount

Summary

Compensation for loss of office

£20,000

£30,000 exemption applies.

PILON – Non-contractual

£15,000

Unused part of the £30,000 exemption is available.

Total

£35,000

 

Exemption

£30,000

 

Tax due on

£5,000

 

Table 2 – Position post 6 April 2018

Details

Amount

Summary

Compensation for loss of office

£20,000

Amount paid in excess of the PENP. Treated as exempt for tax purposes.

PILON – Non-contractual

£15,000

Subject to tax

Total

£35,000

 

Exemption

£20,000

 

Tax due on

£15,000*

 

*It is proposed that employer’s National Insurance will be due on taxable termination payments with effect from 6 April 2019.

Injury to feelings

The changes within the legislation will also preclude any payment for “injury to feelings” from benefitting from any tax exemption.

Foreign Service exemption

The new rules will also remove the entitlement to the Foreign Service exemption for employees who are UK resident (based upon the Statutory Residence Test) in the year in which the employment is terminated. Consequently, this will prevent an employee for claiming relief for any part of the work undertaken overseas.

The Government’s intention is clear, they want all UK resident taxpayers will be treated the same, regardless of whether the payment is in recognition of any duties performed overseas.  However, the Foreign Service exemption will continue to apply where a payment relates to a change in the individual’s duties or to a change in the earnings from the employment.

The proposed changes to the Foreign Service exemption will not apply to seafarers.

National Insurance

The proposed changes to the National Insurance treatment of a termination payment has been deferred until 6 April 2019.

The intention is for the employer to subject to a Class 1A National Insurance change on any payments made more than £30,000. It is proposed that the National Insurance payment will be due for payment via the payroll in the pay period it is due to be paid. It will be interesting to see if there are any further developments before the National Insurance Bill 2018 is published.

The delay for implementing the National Insurance changes will provide employers with a limited period of time to help manage the costs associated with any larger termination payments which are being contemplated.

Conclusions

The change to the tax treatment of termination payments will come into effect from 6 April 2018 but the National Insurance changes will not apply until 6 April 2019.

Where an employer of in the process of reducing their headcount then careful consideration needs to be given to whether the payment should be made before either 5 April 2018 or 2019. This will be especially important where:

  • Currently, there is no PILON clause within the employment contract; or
  • Employees may currently qualify for Foreign Services exemption which they could lose after 5 April 2018; or
  • Larger termination payments are being contemplated.

The delay in implementing the changes for National Insurance purposes will be good news for some employers. However, employers should act now if they want to maximise both their position and to help protect the reliefs available to their employees. 

For further information, please contact Katharine Arthur, Head of Tax, (+44(0) 20 7969 5610), or any member of haysmacintyre’s tax team.

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